Tuesday, July 17, 2007

Supply-side math

An economist weighs in with a trashing of a Wall Street Journal editorial that uses atrociously bad math in defense of supply-side economics -- in particular, an attempt to at last locate the elusive Laffer Curve. There's a more detailed discussion over at Kevin Drum's blog.

The WSJ's purpose was to show a "sweet spot" for taxation, where if you raised rates beyond that tax revenue actually went down. But there are several problems with their chart.

One is that they're using corporate taxes as their yardstick. But corporate taxes make up a much higher percentage of revenue in a tiny tax haven like Luxembourg than they do in large, diversified economy like the United States. And the main outlier, Norway, has huge corporate tax revenues because of its state oil monopoly. Those factors should have set off alarm bells for whomever was preparing the chart.

They compound the problem by drawing their line through Norway instead of either throwing out that data point (as an obvious outlier) or at least averaging it with the other data points. Then, as Drum points out, if the curve is to be believed, tax revenue crashes to zero at around 33 percent -- even though the chart itself shows companies with rates higher than that having significant tax revenue.

Third, we have no idea how or why they chose the countries in the sample -- indeed, some of the data points are unlabeled. There's no way to tell if the sample is representative, complete, or meaningful.

But mostly, the graph doesn't show any significant conclusions. For example, Australia has one of the highest revenue figures with a corporate tax rate of about 31 percent. But three unnamed countries have significantly lower revenue with the same tax rate. The only possible conclusion is that corporate tax rate is simply not the major influence at play.

As one of the commenters at the first link points out:

This (the chart) is the dumbest thing I've ever seen, and I've seen a lot. You don't have to be an economist. All you have to be is somebody who knows what a scatter diagram is.

Silly people.

The basic idea of the Laffer Curve is reasonable -- that there's a sweet spot where taxation is high enough to generate substantial revenue, but not so high that it discourages work and investment. It's simply an expression of the law of diminishing returns. The devil is in the details: where exactly is that sweet spot? Nobody has yet shown it.

It doesn't help that one of the main assumptions behind the Laffer Curve probably is false: that a 100% tax rate will generate no tax revenue because nobody will work if all their earnings are confiscated.

It's false because many people work for reasons other than money. If you love the work, you'll do it for free. Work provides a sense of accomplishment, a chance to get out of the house, a sense of worth.

Further, the Laffer argument assumes that the confiscated money is poured down a hole in the ground. In reality, it's fed back into the economy -- where it may, for instance, provide a worker at a state-owned factory with food and shelter in return for work. In other words, there are ways to incentivize people to work that don't involve money.

I'm certainly not arguing in favor of state socialism. While revenue at a 100% tax rate wouldn't be zero, it wouldn't be very high, either. Money also is the best incentive for a free society, letting people make choices and reap the benefits or drawbacks of those choices. It also seems to work the best for unlocking creativity and hard work, or persuading people to go to the trouble of pursuing specialty training or performing dangerous or unpleasant jobs. I'm just noting the practical reasons why nobody knows whether the tax sweet spot is 25 percent or 80 percent.

The WSJ folks are still idjits.

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Anonymous Anonymous said...

I do know that if we're allowed to keep more of our own hard-earned money----we are more likely to start businesses, invest or spend, and in turn, generate more tax revenues for the country. And it's all a plus to the economy; just like now.

And that's a good thing.

7/18/2007 12:05 PM  
Blogger Sean Aqui said...

True to a point, but only a point -- which is the main point being made here.

No matter how much of your hard-earned money you keep, you still need infrastructure (roads, Internet, communications) to get your products to market, police and regulators to protect property and enforce the rules of commerce, a military to protect the peace so you can operate in a stable environment, courts to adjudicate complaints, inspectors to ensure products aren't tainted or fake, etc. These are services that can only be provided through taxes.

Low taxes are not an absolute good. All things being equal, lower taxes are better than higher taxes. But whether a given taxation level is good or bad really depends on what you're getting for your money.

7/18/2007 2:44 PM  

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